The concept, theory and practice regarding Options trading in the USA started in the early 19th Century. In the initial stages the contracts were referred to as privileges and were not traded on an exchange or stock markets (Jabbers, 1998). The main reason was due too lack of secondary market and therefore it was a daunting task for the sellers and buyers to locate each other and trade options.
This sector of business has gradually grown and developed with grate assistance of the technological advancement, especially internet, media and electronic trading since these accelerators inputs competitiveness and accessibility to both buyers and sellers. Therefore in this light, the option trading concept requires clear understanding before practicing, consulting or advising in real investment world.
According to Richard and Stewart (2000) in their work represented by their book Principles of corporate finance, he defines option as a contract between two parties that gives the buyer (taker) the right, but not the obligation, to buy or sell a security at a predetermined price on or before a predetermined date. In order for the taker to acquire this right in the contract needs to pay a premium to the seller (writer).
In other words, option trading involves a contract between the seller and a buyer, whereby a buyer of an option acquires the right but not the obligation to buy or sell an underlying security at a fixed price in the security market. The contract is usually specific in terms of timeline. By this it means that the contract of option trading has a limited time and expires on a fixed date in the future. In this paper, the term option use throughout the paper shall imply the stock option. When we talk about the stock option it touches on the core area of econometrics of stock and security markets (Budwick, 2004).
Econometric implication for the option trading is the fact that options are traded in chunks which is referred to as contract, econometric of stock option encodes that a contract represents 100 shares of the underlying security. Therefore, when there are 200 contracts it shall represent 20,000 of the company in the contract. Option markets include those under European style options like ODAX in Deutsche Boerse, OSMI in Swiss Exchange and ESX in LIFFE both in Europe. The other option markets include those that lie under US style like EUR in Chicago Mercantile Exchange, OYM in Chicago Board of Trade and OZG in Chicago Board of Trade both in US.
Types of options Whenever there is a transaction of either buying or selling, but in this sense the transaction relating to option is referred to as writing the options contract. In regard to option trading, there are two types of options: cal option and put option. Call options Under the call options, the contract gives the taker the right, but not the obligation, to buy the underlying shares at a predetermined price, on or before a predetermined date (John, Mark, 1998, p. 482). Empirically call option can be demonstrated in the following example, if we assume that IBM limited company shares have a last sale price of $ 12.
00, and then an available 3 month option would be an IBM 3 month $12. 00 call. As an implication, the taker into the contract has the right, but not the obligation, to buy 1,000 IMB shares for a price of $12. 00 per share at any time until the expiry of the 3 months period, after the expiry date the right for the taker is invalid. In this transaction the taker pays IBM purchase price or a premium. Put options The contract that relates to the Put options, it usually gives the taker the right but not the obligation to sell the underlying shares at a predetermined price on or before a predetermined date (John, Mark, 1998, p.
489). In this case, the taker of a put is only required to deliver the underlying shares if they exercise the option. In real practice, put option can be exemplary explained by the following example. An available option would be an IBM 3 month $12. 00 put. This grants the taker the right, but not the obligation, to sell 1,000 IBM shares for $12. 00 per share at any time until expiry. In this category of right, the writer of option is paid a premium by the taker. The writer of the put option at this time is obliged to buy the IBM shares for $12.
00 per share if the option is exercised. As opposed to the writer of call option, in put option the writer receives and keeps the option premium whether or not option is exercised. In general, the procedural similarity between put option and call option is that when they are exercised, the shares are traded at the specified price and it is this price that is referred to as strike or exercise price. While the last date for exercising an option is the one that is referred as the expiry date (Jabbers, 1998).
Rights and obligations in call option stipulate that the taker receives the right to buy shares at the exercise price in return for paying the premium to the writer. In return for the transaction, the writer receives and keeps premium but now has the obligation to deliver shares if the taker exercises the option as stipulated by the contract between them. Whereas in put option, the taker receives the right to sell shares at the exercise price in return for paying the premium to the writer. While the writer receives and keeps premium but now has the obligation to buy the underlying shares if the taker exercises (John and Mark, 1998).
Parties to the option contract There two main players in transacting an option. These are the option taker and option writer. The option taker is a technical security trading term referring to the investor or business person anticipating a significant move in a particular share price. Therefore, this investor or the option taker by taking an option, it offers the investor an opportunity to earn a leveraged profit with a known and limited risk (John, Mark, 1998). The second important and vital part to the option trade is the option writer who earns premium for selling options.
In this regard, both the writer in call option case and in put option case usually looks forward for prices to remain steady. However, it should be noted that the right to exercise the option rests entirely with the option taker. (Tables 1 and 2 present the details of parties to the option contract and their characteristics in both call option and put option) Pricing of the options Option pricing is fundamental in option trading since it gives understanding how the premiums are calculated which the core and gives meaning to term trade.
Premium is calculated on two bases of the intrinsic value and the time value (Jabbers, 1998). Time value is based on the investor’s amount he or she is prepared to pay for the possibility that the market might move in your favor during the option life. Time value for the premiums varies within out-of-the-money, at-the-money and in-the-money; but greatest at at-the-money options. The time value is influenced by Time to expiry, Volatility, Interest rates, Dividend payments and Market expectations (Jabbers, 1998).
While on the other hand of the intrinsic value, is derived from the difference between the market price of the underlying shares and the exercise price of the option at any given time. But basically there shall result in variation between the call option and the put option values. Option trade Margins The option margins are tool of design which are designed to protect the financial security of the market. In regard to margin, (Gupta, 2005) states that margin is an amount that is calculated by option stock markets as necessary to ensure that the writer can meet that obligation on day of trading.
Therefore, the margins serve as potential security for investment and smooth option trading. Furthermore, Gupta ( 2005) states that there are two kind of margin dominantly used: the risk margin that covers the potential change in the price of the option contract assuming daily volatility in the price of the underlying security; and secondly, is the premium margin which is the market value of the position at the close of business on daily basis. I really financial implication, it represents the amount that would be required to close out firm’s option position. Benefits of option trading
Budwick (2004), points out various benefits gained through this form of business. First and foremost he [points out that option trading help to a greater deal in risk management for the parties since arrangements involving Put options gives an allowance to hedge against a possible fall in the value of shares you hold. It is a clear way to generate income for parties involved. The income is generated through earning extra income over and above dividends by writing call options against shares one have that can encompass shares bought using a margin lending facility.
Thirdly, the option trade through options allows for building a diversified portfolio for a lower initial outlay than purchasing shares directly. Fourthly, the taker in the option trade the take has time to decide when to exercise in accordance to his or her convenient. And lastly in this paper but not limited to others views, is the fact that there is an element of leverage that provides the potential to make a higher return from a smaller initial outlay than investing directly (Schaffer and Schaffer 1997). Conclusion To sum up the paper, the paper has examined the practices and practices of option trading.
In the exclusive discussion of the paper, it has discussed on major aspect of the historical aspect of the option trading, types of options where it discussed Call options and Put options. Then it has moved to discussing the Parties to the option, pricing of the options and the Option trade Margins that are designed to protect the option traders. Lastly it has examined possible benefit of trading in option. , however it can not fail to point out that there are dark side of the option trading which is the risks option trading.Therefore, it should be noted that option trading is not suitable for all kind of investors.
Richard, B and Stewart, M. (2000) Principles of corporate finance: New York, McGraw-Hall. Gupta, S. (2005), Financial Derivatives; theory concepts and problems: New dell, PHI learning pvt. Ltd Schaffer, B. & Schaffer, J (1997) the option Advisor; wealthy building Techniques using Equity and index option: John wily and Sons, New York. Jabbers, G. & Budwick, P. (2004) the option Trader handbook: New York, John wily and Sons. John c, and Mark, R. (1998), Option markets: New York, Prentice hall.